Monday, March 17, 2008

End of the beginning of the Credit Crunch

The emergency rescue of Bear Stearns brings down one of the most original investment banks on Wall Street. The Bear Stearns culture was not the same ethos as the white shoe investment banks- of which its new owner, JP Morgan, is the classic example. Instead of connections and education, Bear preferred to focus not so much on CFAs and MBAs, but rather "PSDs"- poor, smart, but with a desperate desire to become rich. Over twenty years, the legendary chairman, Ace Greenberg wrote folksy and thoughtful "Letters from the Chairman" pointing out the virtues of thrift and discipline in the financial markets. Great Bear alumni included Henry Kravis, Jerome Kohlberg and George Roberts, the founders of the most spectacularly successful fund; KKR.

In the end, it was other funds that brought down the house founded to trade equities in 1923. Bear, as the quintessential trading house, had followed the money from equities and into credit, and in particular the esoteric world of asset backed securities. Eventually the impact of the sub prime eroded the capital of two Bear Stearns structured credit funds to the point of collapse. It was the bail out of two of its structured credit funds in June 2007 that expanded the sub prime melt down into the general domain.

Now the gutsy traders have been bought for around 10 cents on the Dollar by a bank whose roots lie in the most aristocratic end of Wall Street, where connections, even now generate business. At the same time, the Fed continues to inject further liquidity through credit lines and interest rate cuts.

In my judgement, the Fed in its determination to reduce the impact of the downturn has made a significant mistake. The cost of the attempted rescue of the credit markets has been a Dollar crash on a scale not seen in living memory. Essentially the credit meltdown- with the associated write-offs- has not only undermined confidence, it has actually reduced the real economic value of the US currency.

Yet still, there is an expectation that the impact of de-leveraging can be mitigated, and perhaps it can, at the margin, but the reality is that the Fed has undermined the value of the US currency to the point where a permanent structural adjustment in the US Dollar price has taken place already. The US consumer- overextended on property leverage and maxed out credit cards- is now retrenching. Yet a dramatic increase in exports that one might have expected from the drastic fall in the Dollar is slow in coming, as confidence falls across the planet.

The Dollar crisis will persist until the US financial system can be seen to have adjusted to the new conditions- a process that could still take several years. In the meantime, the knock on effect in terms of property prices and general leverage is triggering more problems in Spain, Ireland and the UK, who have a similar addiction to property credit as the US market.

Asset prices in Europe are falling, but are still not looking as bad as the US- though it seems to me that the contagion in the Mortgage backed securities market has not reached anything like the adjustment of 30%-40% that seems to be the endgame in the US. The markets are still in a state of denial as to how bad the situation actually is.

The fall of Bear Stearns may not be the endgame in the US, either. We will see further bad figures from Lehman Brothers this week, and continuing write offs across the system. Gold will remain strong, at least until the end of the Indian bridal season. Confidence in the Dollar might have been maintained by a tighter monetary policy, but in simple panic Ben Bernanke and co. may have eased the scale of the downturn, yet at the same time they have ensured that it will go on for far longer. I can see no buying opportunity until the markets accept that.

Predicting the future is largely impossible- as Nasim Nicholas Taleb work explains so well- understanding the present is easier. Nevertheless the lack of clarity in the level of asset back security losses continues to undermine confidence. It may take a further round of losses before a new sense of reality sinks in and only then can I see a floor being put on the overall value of the market. This floor may still be months away. The fall of the House of Bear, Stearns & Co. is a milestone on the journey. It is unlikely to be the final destination of the global breakdown.


fh said...

Excellent analysis, as always. With the possible exception of the falling real value of dollar (esp sovereign) debt -- a mixed bag as a positive because it still has to be sold somehow -- there is simply no sign of any light at the end of this tunnel.

"State of denial" is an apt description, and applies in spades to that thing called a budget, or whatever it was, presented by Mr. Darling. Plastic bags indeed!

Cicero said...

The de facto devaluation of the USD has already made US government debt much less attractive. The risk- small at the moment, but possible- that the Fed is running is that the US lose their AAA for non Dollar debt, which would be something of an earthquake.

fh said...

And what of UK gov debt?

Which leads on to thoughts about your newest post, about Lib-Dem tax policy (among other things). With Britain's current appalling fiscal position, is it sensible or even credible to posit tax cuts now?

Cicero said...

Well, apart from the Laffer curve, I would say that tackling the amazing inefficiency of the public sector and returning the savings to the taxpayer is something that any truly prudent government would have done already, however we do not have a prudent government. If the fiscal position weakens further, then it is going to be a tough call. Nevertheless the fiscal burden is- in my view- already hurting the wider economyaand unless it is reduced a future recovery could be a whole lot slower.

fh said...

Agreed on the cost savings possible, but it's a timing issue, isn't it? Gotta do one before the other.

Regarding the Laffer curve -- well, sure, it'd probably be good to be able to leave more cash with lower-income folks. But what's really needed is root and branch stuff -- but again, only after root, branch and whole forests have been trimmed back in government.

And with that, I really ought to move on to your new post -- because none of this sounds very Lib-Dem, does it?

Anonymous said...
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Jeremy Jacobs said...

Think you've got a spam problem. You OK James?